Although the actual definition of a hedge fund is hard to pin down to one simple explanation, these unique investment vehicles are identifiable by several key characteristics involving the size, style, fees and leverage options involved.
Hedge funds use different strategies to compensate against losses. Like mutual funds, these are private pools of money that can be invested in many different legal investments to maximize their returns. However, they differ from mutual funds in that there are no restrictions as to where or in what they can invest. Because hedge funds are complicated and often involve investments beginning with $400,000 – $500,000, they are not generally recommended for the novice investor. In fact, only the sophisticated, experienced investor should attempt to succeed with hedge funds.
As with other types of investments, the level of risk involved varies considerably depending on the fund. Those offering short-term, high return investments are typically either uninformed and inexperienced or worse, fraudulent. It is quite possible to lose your entire initial investment if your hedge fund manager makes the wrong decision. For these and other reasons, the US Securities Exchange Commission, as well as regulatory agencies around the globe, have limited hedge fund investment availability to those quite literally able to afford the loss, should the hedge fund go belly up. Accredited and institutional investors can take their chances on a hedge fund; the average-Joe stock market player cannot. Understand that hedge funds are not allowed to advertise themselves; if you are approached via the internet, cold calling or in person and given an opportunity to invest in a hedge fund, it is probably not legitimate.
Before investing in any hedge fund, an investor must understand several important factors. Hedge funds are subject to two different types of fees: management and performance fees. Each fund will have a minimum investment level. A new player has also surfaced recently in the hedge fund game: the Multi-Manager Hedge Fund, or fund of funds. While the risk involved is reduced by the fact that the fund is invested in a diverse subset of funds, you also pay greater management fees. The risk is less and so are the returns. Off-shore hedge funds may also be an attractive option, as they are subject to different (or no) taxes. However, as with any investment, the potential for lucrative returns increases in tandem with the degree of risk.
Hedge funds are a great option for high net worth investors, provided they have done their homework and understand the terms and practices involved.